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What Is An Initial Coin Offering, Or ICO, And Which Should You Invest In?

"What the hell is an ICO?" — a seasoned fund manager asked me last year when I mentioned Ethereum’s multimillion-dollar token sale. At first, he thought I was talking about the made-up terrorist group from Netflix, Inc. (NASDAQ: NFLX)’s “House of Cards.”

At the time, Initial Coin Offerings were in their infancy, so many people didn't fully understand them. Twelve months have gone by, and many still can’t fully grasp the entirety of such complex financial instruments.

Now ICOs are hotter than ever, so Benzinga spoke to a couple of experts to get a clear, step-by-step explanation of how these cryptocurrency crowdfunding mechanisms work, the risks and potential rewards, and a few tips on how to pick the right ones to invest in.

Initial Coin Offering Basics

An ICO can be, in some ways, similar to an initial public offering.

“It’s a process where individual capital, or investors, are investing in a company or aggregating capital to a company under a common funding cause,” Vincent Molinari, Wall Street veteran, told Benzinga during a recent conversation — Molinari is the CEO of Liquid Markets Group and co-founder of the Blockchain Commission, which was launched at the United Nations’ General Assembly.

But, unlike an IPO, where a company sells shares of stock, which implies ownership, an ICO entails the sale of tokens: digital assets or technology-based contracts with a certain monetary value, expected to surge over time — like bitcoin. In most cases, these smart contracts have been funded by cryptocurrencies like bitcoin or Ethereum.

Another big difference is that ICOs haven’t been regulated by the SEC in the same way that IPOs are regulated, although some activists in the sector are advocating to get government agencies and legislators involved to a certain extent, trying to get those digital assets deemed securities. Thus, ICOs would be conducted in a regulated manner to ensure adherence to provisions for Anti-Money Laundering, Know Your Customer and Investor Protection. For the time being, however, most ICOs are being positioned as utilities, “which do not have a framework and are speculative in nature as there is no economic tie-in or commonality from the issuer to the token holder,” Molinari continued.

In this context, the SEC has warned the public about the risk of potential scams and “pumps and dumps” in ICOs conducted by publicly traded companies. In a similar fashion, the UK’s Financial Conduct Authority noted the elevated risk and speculative nature of ICOs. Nonetheless, this doesn't mean that all ICOs are scams; some offer great value for investors looking for alternative assets.

Impact Investing

It’s important to consider ICOs and other forms of investing in unregistered securities as a form of impact investing, Molinari said. Beyond the actual capital returns, which are of course an important element to this equation, ICOs have the ability to deliver societal or environmental. Investing in ICOs and other non-registered assets is a way of bringing back capital formation to the broad public, democratizing the process, and providing new ways for “companies that create jobs and innovate” to access capital.

“In recent years, there’s been a tremendous decrease in the number of IPOs,” Molinari said. “This means fewer exit strategies for IPO investors, and that the size of the remaining IPOs is in the billions of dollars. So, we’ve lost our lower-lever and mid-tier IPO process; and this is important because our biggest job creators and engines of growth come from our private sector. So, if you are not feeding the private sector with capital to create jobs and grow, you are not having economic expansion.”

ICOs and their innovative technology offer an interesting solution to this problem, generating new avenues to raise capital without the need to incur the massive costs of being a public company.

“Christopher Pallotta and I have formed a new company, called Templum, with the intention to merge the worlds of emerging technology with capital formation in a regulated framework. Templum operates at the intersection of securities law modernization and innovative technology. We’ve embedded the distribution of securities into a tokenized smart contract in the form of a share structure, profit participation or yield instrument, with a proper incentive component,” Molinari said. “This would create a security that has all the rights and investor protection of a traditional instrument in a tokenized structure.”

Pallotta, Templum co-founder and CEO added, “Templum was established to bridge the gap between the innovative and efficient ICO mechanism and the established regulatory frameworks that help to mitigate risks for issuers and investors. Bringing the ICO market into compliance with current regulations will be a big step toward increasing widespread acceptance of ICOs.”

How To Pick The Right ICO

One final aspect discussed with Molinari is how to pick the right ICOs to invest in and how to avoid the riskiest ones.

Before investing in an ICO, it’s important to check what the company does, its product development roadmap and how it plans to use funds raised in its ICO, Molinari suggested. “A big problem is overfunding. There is often no rationale or logic to the amount of capital being raised; they are just raising all they can, without having a clear plan for the use of proceeds.”

However, the first thing Molinari and his partners review is who is behind an ICO, who forms the management team, and who’s doing the “bad actor check” — if anyone is. “Knowing who’s involved in a company is a fundamental part of investor protection, as these people are parting with money.”